Question

Gold Star Industries is contemplating a purchase of computers. The firm has narrowed its choices to the SAL 5000 and the HAL 1000. The company would need seven SALs, and each SAL costs $3,150 and requires $360 of maintenance each year. At the end of the computer’s eight-year life, each one could be sold for $175. Alternatively, the company could buy eight HALs. Each HAL costs $3,650 and requires $415 of maintenance every year. Each HAL lasts for six years and has a resale value of $170 at the end of its economic life. The company will continue to purchase the model that it chooses today into perpetuity, and the tax rate is 21 percent. Assume that the maintenance costs occur at year-end. Depreciation is straight-line to zero. What is the EAC of each model if the appropriate discount rate is 8 percent? (Your answers should be a negative value and indicated by a minus sign. Do not round intermediate calculations and round your answers to 2 decimal places, e.g., 32.16.)

Answer 1

Calculation of Equated annual cost (EAC) of each model:

Two Computer models are available

Model 1 - SAL 5000

Model 2 - HAL 1,000

EAC for Model SAL 5000:

Company requires 7 SAL's

Each SAL cost = $3,150

Maintenance cost for each SAL = $360

Life of computers of SAL Model = 8

Salvage value of each SAL = $175

Total salvage value = 7×175 = $$1,225

Equated Annual cost:

Capital costs = 7×3,150 = $22,050

Present value of annual costs

Particulars	Year 1 to 8
Maintenance cost per annum (360×7)	2,520
Depreciation (22,050)÷8	2,756.25
Total Operating costs	5,276.25
Tax shield @21%	-1,108.01
Total costs	4,168.24
Less: Depreciation	-2756.25
Operating cash outflows	1,411.99
PVAF(8%,8) = [1-1÷(1+k)^n]÷k where k is discount rate and n is no. of years	5.7466
Present value of operating cash inflows [1,411.99×5.7466]	8,114.14

Present value of salvage value

= 1,225×PVF(8%,8)

= 1,225×1÷(1+0.08)^8

= 1,225×0.5403

= 661.87

Equated annual cost(EAC) = [Capital cost + present value of operating cash outflows - present value of Terminal cash inflows]÷PVAF(8%,8)

EAC =( 22,050 +8,114.14 - 661.87)÷5.7466

EAC = 29,502.27÷5.7466

EAC = $5,133.87

EAC for Model HAL 1000:

Given, This model requires 8 computers

Each HAL's cost = $3,650

Maintenance cost for each HAL = 415

Life of computers = 6 years

Salvage value of each SAL = 170

Total salvage value = 8×170 = 1,360

Equated annual cost:

Capital costs = 8×3,650 = $29,200

Present value of annual costs

Particulars	Year 1 to 6
Maintenance cost per annum (415×8)	3,320
Depreciation (29,200)÷6	4,866.67
Total Operating costs	8,186.67
Tax shield@21%	-1,719.20
Total cost	6,467.47
Less: Depreciation	-4,866.67
Operating cash outflows	1,600.8
PVAF(8%,6)	4.6229
Present value of operating cash outflows [1,600.8×4.6229]	7,400.34

Present value of salvage value

= 1,360×PVF(8%,6)

= 1,360×0.6302

= $857.07

EAC = (29,200+7,400.34 - 857.07)÷PVAF(8%,6)

EAC = 35,743.27÷4.6229

EAC = $7,731.79

SUMMARY:

EAC of Model SAL 5000 = 5,133.87

EAC of Model HAL 1000 = 7,731.78

CONCLUSION:

As EAC for Model SAL 1000 is lower, it is preferable